PROPOSED ACCOUNTING FOR INTEREST RATE SWAPS

By Arlette C. Wilson and
G. Robert Smith

Interest rate swaps became popular in the 1980s when the U.S. was in recession and interest rates were high. Long-term fixed-rate loans were difficult to enter into since lenders were concerned about rising rates. This left many companies in a position of financing with short-term floating rate debt. This environment created a market for the interest rate swap.

Rapid development of new derivative products has made it difficult for the Financial Accounting Standards Board (FASB) to provide accounting rules for financial instruments. Although pronouncements exist for futures and forwards, no authoritative rules exist that cover interest rate swaps. Guidance is currently provided by the Emerging Issues Task Force (EITF).

The FASB recently issued an exposure draft that provides proposed accounting for all derivative financial instruments, even those yet to be developed (see "Improved Accounting for Derivatives and Hedging Activities" in the feature article section of this issue). The purpose of this article is to discuss how this proposed approach would change the accounting for interest rate swaps. Illustrations are provided followed by an evaluation of the new approach as it relates to interest rate swaps.

Accounting for Interest Rate Swaps

Currently, no FASB pronouncement deals with accounting for interest rate swaps. However, EITF No. 84-36 provides guidance in this area. Interest rate swaps are generally accounted for as follows:

* Gains or losses related to changes in the swap's fair value are not generally recognized because most swaps are entered into as an integral part of a borrowing arrangement.

* Interest expense is adjusted for the net receivable/payable from the swap
contract.

* Unrealized gains/losses from changes in market value of swaps held for speculative purposes are recognized in current income.

When the swap is designated to effectively change a fixed-rate financial instrument to variable-rate, or a variable-rate financial instrument to fixed rate, the interest is adjusted by the receivable/payable on the swap so that recorded interest is "as if" the entity actually held the variable-rate or fixed-rate instrument. The proposed FASB approach would require all derivatives to be reported at fair value on the balance sheet as assets or liabilities. The proposal does allow for designation of the derivative as a hedge of a cash flow exposure of a future transaction or as a hedge of a market value exposure of an existing asset, liability, or firm commitment. The holding gain or loss from a derivative hedging a forecasted transaction would be deferred as a part of comprehensive income (the proposed accounting for which is concurrently being debated with the derivatives ED) and recognized in current earnings when the transaction is expected to occur. The change in fair value of a derivative hedging market value exposure would be included in current earnings. At the same time, the change in fair value of the asset, liability, or firm commitment being hedged would be recognized in earnings to the extent of offsetting gains or losses on the hedging instrument. Gains and losses on all other derivatives would be included in current earnings.

Accounting for interest rate swaps would depend on the type of swap. A swap of fixed-rate receive and variable-rate pay that effectively swaps a fixed-rate borrowing for variable-rate would be considered a fair value hedge of market value exposure. If a company borrows at a fixed rate, the future cash outflows are fixed even though the market rate changes. As the market rate does change, the present value of the fixed cash outflows at the new market rate reflects the fair value of the liability. If a swap were to effectively change the borrowing to a variable rate, the future cash outflows would fluctuate with the market rate and fair value of the liability would be constant. Therefore the swap would have been effective in hedging a fair value exposure.

A swap of a variable-rate receive and fixed-rate pay that effectively swaps a variable-rate borrowing for fixed-rate would be considered a cash flow hedge. Holding variable-rate debt would result in cash outflows that would fluctuate depending on the market rate. A swap that effectively changes this debt to fixed-rate pay would change the future
cash flows to a constant amount and therefore a successful hedge of future cash flow exposure.

Illustration of Proposed Accounting

Accounting for interest rate swaps is dependent upon whether the swap is for the purpose of hedging fair value or cash flow. All swaps would be carried at fair value. The change in fair value would be included in comprehensive income and reported in stockholders' equity if hedging future cash flow exposure, while included in current earnings if hedging fair value of an asset, liability, or future commitment. The exhibit provides information used to illustrate the proposed accounting for interest rate swaps that follows.

Fixed-Rate Pay Swap. A fixed-rate pay swap used to effectively exchange variable-rate debt for fixed-rate debt would be a derivative hedging future cash flows since it results in fixed future cash flow. Figure 1 demonstrates how a fixed-rate pay swap hedges cash flow exposure by resulting in constant cash outflows. This type of swap guards against the possibility of rising rates, but if the variable rate received remains below the fixed-rate pay, the company will have a greater total cash outflow than they otherwise would. However, they do know what the outflow will be.

The accounting for this type of swap is to record the instrument at its fair value and report the unrealized gain or loss in stockholders' equity. To calculate fair value, the swap is assumed to be unwound. That is, a second swap is assumed to be entered into to unwind the original swap. The first section of Figure 2 demonstrates the unwinding. Co. X originally enters into a fixed-rate pay of 8% for LIBOR. To unwind, Co. X is assumed to enter into a fixed-rate receive on the financial statement date. The fixed-rate receive on Dec. 31, 1996 is 8.6%. The LIBOR received on the original swap is used to pay the LIBOR on the second swap. The fixed-rate receive of 8.6% is used to pay the fixed-rate pay of 8%, and Co. X is actually .6% of the notional amount better off. This excess cash inflow is assumed to occur for the remaining two years of the swap. These cash inflows would be $3,000 at the end of each six months since the swap is settled each six months. These payments are brought back to present value using the treasury rate of 7% to determine the swap's approximate fair value of $11,109. Fair values can also be obtained from dealers who may use similar but more finely tuned methods such as a two-year treasury rate for one year and the one-year treasury rate for the other year. The following adjusting entry would be made at Dec. 31, 1996:

SWAP 11,019

Gain on Swap (11,019)

The SWAP account would be
included with assets while the Gain would be reported as comprehensive income and included in stockholders' equity. As cash is received or paid
each period, the gain or loss is essentially realized as an adjustment to interest expense with the following entries:

Cash XX

SWAP (XX)

Gain on Swap XX

Interest Exp (XX)

The amount of the "XX" would be equal to the settlement cash received or paid. The SWAP account would then be adjusted from its remaining balance to its current fair value.

Variable-Rate Pay Swap. A variable-rate pay swap effectively swaps fixed-rate debt for variable-rate debt that hedges the fair value of the liability. Fixed-rate debt would vary in fair value as the market rate changes, but swapping for variable-rate debt would result in the debt remaining constant in fair value since the cash outflows would change as the rate changes.

The accounting for this type of swap is to record the instrument at its fair value and include this change in current earnings. At the same time the fixed-rate debt would be marked to fair value and its change included to offset the unrealized gain or loss on the swap. How effective the hedge is depends on the extent of offset. Fair value calculation of the swap is similar to that of the fixed-rate swap. The second section of Figure 2 demonstrates the unwinding process for a fixed-rate receive swap. Since 8% is received, but 8.7% would have to be paid to unwind, .7% of the notional amount is assumed to be owed for the next two years. Assuming cash settlements every six months and discounting the cash outflows using the treasury rate, fair value of the swap obligation arising from the swap is $12,855.

The journal entry would be:

Loss on Swap 12,855

SWAP (12,855)

The loss would be included in current earnings and the SWAP account would be reported as a liability.

At the same time, the debt would be marked to its fair value. To determine this fair value, the future cash outflows of $40,000 each six months for the next two years and $1,000,000 at the end of two years are discounted using the market rate for that type of loan to arrive at the following fair values:

Interest $143,840

Principal 841,780

$985,620

This results in a holding gain of $14,380 since fair value of the debt is less than the carrying value. The unrealized loss from the swap and the unrealized gain from the debt are not the same because different interest rates are involved. The approach, as proposed by the FASB, would report in earnings the full gain or loss on the derivative and the loss or gain on the hedged item up to the amount that provides offset. Therefore the following entry would be made to adjust the debt to fair value:

Discount N/Pay 12,855

Gain on Note (12,855)

Even though the gain was calculated as $14,380, only an amount up to $12,855 would be reported in earnings. Therefore the fair value of the debt would not be reported on the balance sheet, but some amount between cost and fair value. If the gain were less than $12,855, it would be recorded at the lesser amount and be stated at fair value.

Evaluation of Proposed Accounting

When dealing with complex accounting issues, the FASB strives to develop standards that provide information that is relevant and reliable. This information should be comparable between companies and consistent from year to year within the same company, but should not be required if perceived benefits of information do not exceed the costs of providing the information. In addition, the information is of little value if it is not understandable. The proposed approach to accounting for derivatives as it relates to interest rate swaps is discussed as follows.

Relevant. Fair market value is generally considered relevant information if it can be obtained on a timely basis. Fair values are understandable and allow for visibility of the instruments on the financial statements. Although fair values of derivatives continually change, they do allow users to assess the current risks of the company. However, the proposed accounting treatment may result in hedged assets or liabilities being reported at an amount other than historical cost or fair value. If a derivative hedges an asset or liability, the full loss or gain on the derivative is reported in current earnings with the gain or loss on the hedged item up to the amount of offset. As shown earlier, when the company entered into a variable-rate pay swap to hedge a fixed-rate debt, the debt was not marked to its fair value, but only enough to recognize a gain in the same amount as the loss on the swap. Therefore the debt was not reported at fair value or historical cost. In addition, the fair value of an interest rate swap represents what would be received or paid to unwind the swap at that point in time, even though the company has no intention of unwinding the swap.

Reliable. One characteristic of reliability is verifiability. Derivatives traded on exchanges have readily available fair values. It is a little more difficult to determine fair value for those instruments traded off exchanges, especially exotic derivatives since these are designed as needed. However, interest rate swaps are traded enough to obtain quotes from dealers. Although different dealers will provide different quotes, there should not be a material difference.

Another characteristic of reliability is that the measurement represents what it purports to represent. If a swap has been entered into to change fixed-rate debt to variable-rate debt or vice versa and the intent is to hold the swap for this purpose until maturity, the fair value may not truly represent the value of the swap to the company. However, the fair value does indicate whether the company is better or worse off than if it had never entered into the swap. For example, assume a company entered into an eight percent fixed-rate pay swap to effectively convert variable-rate debt to fixed-rate debt. If the variable rate were seven percent at the balance sheet date, the fair value would be reported as a liability indicating that the company would have been better off without the swap. That is, the company could be paying seven percent (at least until the rate is adjusted again), and yet it is locked in at eight percent.

Comparable. Probably the greatest improvement with this new approach is the comparability that will exist. Under current guidance, the required accounting treatment may differ depending on the type of instrument used to hedge. For example, futures and forwards are similar instruments and yet futures can hedge anticipated transactions, but forwards can only hedge future commitments. Existing guidance is also inconsistent related to risk assessment-- transaction basis for some and entity basis for others. In addition, companies may have developed different practices for those instruments not specifically covered. Comparability among companies will be greatly increased by requiring all derivatives to be reported at fair value.

Cost/Benefit Constraint. The proposed approach is relatively simple, but still accommodates many hedging strategies. The consistency, comparability, and understanding it provides should be perceived greater than the cost involved in implementing this new accounting treatment of derivatives. *

Arlette C. Wilson, PhD, CPA, is a
professor of accounting and G. Robert Smith, PhD, CPA, an assistant professor of accounting at Auburn University.

EXHIBIT

INFORMATION FOR EXAMPLES

FIGURE 2

ASSUMED UNWINDING OF FIXED-RATE PAY AND
FIXED-RATE RECEIVE ORIGINAL SWAPS

Editor:
Douglas R. Carmichael PhD, CPA Baruch College